lecture’10’ the’monetary’system’...

Lecture 10 The Monetary System

(Ch29)

In this chapter, look for the answers to these questions

• What assets are considered “money”? What are the func@ons of money? The types of money?

• What is the Federal Reserve?

• What role do banks play in the monetary system? How do banks “create money”?

• How does the Federal Reserve control the money supply?

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What Money Is and Why It’s Important •  Without money, trade would require barter, the exchange of one good or service for another.

•  Every transac@on would require a double coincidence of wants—the unlikely occurrence that two people each have a good the other wants.

•  Most people would have to spend @me searching for others to trade with—a huge waste of resources.

•  This searching is unnecessary with money, the set of assets that people regularly use to buy g&s from other people.

The 3 Func@ons of Money

•  Medium of exchange: an item buyers give to sellers when they want to purchase g&s

•  Unit of account: the yards@ck people use to post prices and record debts

•  Store of value: an item people can use to transfer purchasing power from the present to the future

The 2 Kinds of Money

Commodity money: takes the form of a commodity with intrinsic value

Examples: gold coins, cigareWes

Fiat money: money without intrinsic value, used as money because of govt decree

Example: the U.S. dollar

©kao/ShuWerstock.com

© Studio Flash/ShuWerstock.com

The Money Supply

•  The money supply (or money stock): the quan@ty of money available in the economy

•  What assets should be considered part of the money supply? Two candidates:

– Currency: the paper bills and coins in the hands of the (non-‐bank) public

– Demand deposits: balances in bank accounts that depositors can access on demand by wri@ng a check

Measures of the U.S. Money Supply

•  M1: currency, demand deposits, traveler’s checks, and other checkable deposits. M1 = $2.6 trillion (September 2013)

•  M2: everything in M1 plus savings deposits, small @me deposits, money market mutual funds, and a few minor categories. M2 = $10.8 trillion (September 2013)

The distinction between M1 and M2 will often not matter when we talk about

“the money supply” in this course.

Central Banks & Monetary Policy

•  Central bank: an ins@tu@on that oversees the banking system and regulates the money supply

•  Monetary policy: the sebng of the money supply by policymakers in the central bank

•  Federal Reserve (Fed): the central bank of the U.S.

The Structure of the Fed The Federal Reserve System consists of:

–  Board of Governors (7 members), located in Washington, DC

–  12 regional Fed banks, located around the U.S.

–  Federal Open Market CommiGee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks. The FOMC decides monetary policy.

Bank Reserves •  In a fracHonal reserve banking system, banks keep a frac@on of deposits as reserves and use the rest to make loans.

•  The Fed establishes reserve requirements, regula@ons on the minimum amount of reserves that banks must hold against deposits.

•  Banks may hold more than this minimum amount if they choose.

•  The reserve raHo, R = frac@on of deposits that banks hold as reserves = total reserves as a percentage of total deposits

Bank T-‐Account •  T-‐account: a simplified accoun@ng statement that shows a bank’s assets & liabili@es.

•  Example: FIRST NATIONAL BANK Assets Liabilities

Reserves $ 10 Loans $ 90

Deposits $100

!  Banks’ liabilities include deposits, assets include loans & reserves.

!  In this example, notice that R = $10/$100 = 10%.

Banks and the Money Supply: An Example

Suppose $100 of currency is in circula@on. To determine banks’ impact on money supply, we calculate the money supply in 3 different cases:

1. No banking system

2. 100% reserve banking system: banks hold 100% of deposits as reserves, make no loans

3. Frac@onal reserve banking system


CASE 1: No banking system Public holds the $100 as currency.

Money supply = $100.


CASE 2: 100% reserve banking system

Public deposits the $100 at First Na@onal Bank (FNB).

FIRST NATIONAL BANK Assets Liabilities

Reserves $100 Loans $ 0

Deposits $100

FNB holds 100% of deposit as reserves:

Money supply = currency + deposits = $0 + $100 = $100

In a 100% reserve banking system, banks do not affect size of money supply.


CASE 3: Frac@onal reserve banking system

Depositors have $100 (Outside Money) in deposits, borrowers have $90 (Inside Money) in currency.

Money supply = C + D = $90 + $100 = $190 (!!!)

FIRST NATIONAL BANK Assets Liabilities

Reserves $100 Loans $ 0

Deposits $100

Suppose R = 10%. FNB loans all but 10% of the deposit:

10 90


How did the money supply suddenly grow? When banks make loans, they create money.

The borrower gets

– $90 in currency—an asset counted in the money supply (Inside Money)

– $90 in new debt—a liability that does not have an offsebng effect on the money supply

CASE 3: Fractional reserve banking system

A fractional reserve banking system creates money, but not wealth.

Inside Money ≠ Welath



If R = 10% for SNB, it will loan all but 10% of the deposit.

SECOND NATIONAL BANK Assets Liabilities


Deposits $ 90

Borrower deposits the $90 at Second National Bank.

Initially, SNB’s T-account looks like this: 9

81



If R = 10% for TNB, it will loan all but 10% of the deposit.

THIRD NATIONAL BANK Assets Liabilities


Deposits $ 81

SNB’s borrower deposits the $81 at Third National Bank.

Initially, TNB’s T-account looks like this: $ 8.10

$72.90



The process continues, and money is created with each new loan.

Original deposit = FNB lending = SNB lending = TNB lending = . . .

$ 100.00 $ 90.00 $ 81.00 $ 72.90 . . .

Total money supply = $ 1000.00

In this example, $100 of reserves

generates $1000 of money.

The Money Mul@plier

•  Money mulHplier: the amount of money the banking system generates with each dollar of reserves or (Outside Money + Inside Money)/Outside Money.

•  The money mul@plier equals 1/R. •  In our example,

R = 10% money mul@plier = 1/R = 10 $100 of reserves (outside money) creates $1000 of (total) money

A C T I V E L E A R N I N G 1

Banks and the money supply


While cleaning your apartment, you look under the sofa cushion and find a $50 bill (and a half-eaten taco). You deposit the bill in your checking account. The Fed’s reserve requirement is 20% of deposits.

A. What is the maximum amount that the money supply could increase?

B. What is the minimum amount that the money supply could increase?

A More Realis@c Balance Sheet •  Assets: Besides reserves and loans, banks also hold securi@es.

•  Liabili@es: Besides deposits, banks also obtain funds from issuing debt and equity.

•  Bank capital: the resources a bank obtains by issuing equity to its owners – Also: bank assets minus bank liabili@es

•  Leverage: the use of borrowed funds to supplement exis@ng funds for investment purposes

A More Realis@c Balance Sheet

MORE REALISTIC NATIONAL BANK Assets Liabilities

Reserves $ 200 Loans $ 700 Securities $ 100

Deposits $ 800 Debt $ 150 Capital $ 50

Leverage ratio: the ratio of assets to bank capital

In this example, the leverage ratio = $1000/$50 = 20

Interpretation: for every $20 in assets, $ 1 is from the bank’s owners, $19 is financed with borrowed money.

Leverage Amplifies Profits and Losses

•  In our example, suppose bank assets appreciate by 5%, from $1000 to $1050. This increases bank capital from $50 to $100, doubling owners’ equity.

•  Instead, if bank assets decrease by 5%, bank capital falls from $50 to $0.

•  If bank assets decrease more than 5%, bank capital is nega@ve and bank is insolvent.

•  Capital requirement: a govt regula@on that specifies a minimum amount of capital, intended to ensure banks will be able to pay off depositors and debts.

Leverage and the Financial Crisis

•  In the financial crisis of 2008–2009, banks suffered losses on mortgage loans and mortgage-‐backed securi@es due to widespread defaults.

•  Many banks became insolvent: In the U.S., 27 banks failed during 2000–2007, 166 during 2008–2009.

•  Many other banks found themselves with too liWle capital, responded by reducing lending, causing a credit crunch.

The Fed’s Tools of Monetary Control •  Earlier, we learned money supply = money mul@plier × bank reserves

•  The Fed can change the money supply by changing bank reserves or changing the money mul@plier.

How the Fed Influences Reserves

•  Open-‐Market OperaHons (OMOs): the purchase and sale of U.S. government bonds by the Fed. –  If the Fed buys a government bond from a bank, it pays by deposi@ng new reserves in that bank’s reserve account. With more reserves, the bank can make more loans, increasing the money supply.

– To decrease bank reserves and the money supply, the Fed sells government bonds.

How the Fed Influences Reserves •  The Fed makes loans to banks, increasing their reserves. –  Tradi@onal method: adjus@ng the discount rate—the interest rate on loans the Fed makes to banks—to influence the amount of reserves banks borrow

– New method: Term Auc)on Facility—the Fed chooses the quan@ty of reserves it will loan, then banks bid against each other for these loans.

•  The more banks borrow, the more reserves they have for funding new loans and increasing the money supply.

How the Fed Influences the Reserve Ra@o so money mul@plier

•  Recall: reserve ra@o = reserves/deposits, which inversely affects the money mul@plier.

•  The Fed sets reserve requirements: regula@ons on the minimum amount of reserves banks must hold against deposits. Reducing reserve requirements would lower the reserve raHo and increase the money mulHplier.

•  Since 10/2008, the Fed has paid interest on reserves banks keep in accounts at the Fed. Raising this interest rate would increase the reserve raHo and lower the money mulHplier.

Problems Controlling the Money Supply

•  If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls.

•  If banks hold more reserves than required, they make fewer loans, and money supply falls.

0

400,000

800,000

1,200,000

1,600,000

2,000,000

2,400,000

2,800,000

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2000 2005 2010 2015

research.stlouisfed.org

M1MoneyMultiplier(right)

TotalReserveBalancesMaintainedwithFederalReserveBanks(left)

(MillionsofDollars)

(Ratio

)

-2

-1

0

1

2

3

4

5

6

2000 2002 2004 2006 2008 2010 2012 2014 2016

research.stlouisfed.org

Source:US.BureauofLaborStatistics

ConsumerPriceIndexforAllUrbanConsumers:AllItems

(Perc

en

tC

han

gef

rom

Year

Ago

)

The Federal Funds Rate

•  On any given day, banks with insufficient reserves can borrow from banks with excess reserves.

•  The interest rate on these loans is the federal funds rate.

•  The FOMC uses OMOs to target the fed funds rate.

•  Changes in the fed funds rate cause changes in other rates and have a big impact on the economy.

•  Now, FFR has been effec@vely zero for more than 7 years, and the OMO is no longer a main monetary policy implementa@on tool for the FED. Why?

The Fed Funds rate and other rates, 1970–2013

0

5

10

15

20

1970 1975 1980 1985 1990 1995 2000 2005 2010

(%)

Fed Funds Mortgage Prime 3 Month T-Bill

Monetary Policy and the Fed Funds Rate

To raise fed funds rate, Fed sells govt bonds (OMO). This removes reserves from the banking system, reduces supply of federal funds, causes rf to rise.

What happened in 2008 then?

rf

F D1

S2

1.75%

F2

S1

F1

1.50%

The Federal Funds market Federal

funds rate

Quantity of federal funds

Summary

•  Money serves three func@ons: medium of exchange, unit of account, and store of value.

•  There are two types of money: commodity money has intrinsic value; fiat money does not.

•  The U.S. uses fiat money, which includes currency and various types of bank deposits.


Summary

•  In a frac@onal reserve banking system, banks create money when they make loans. Bank reserves have a mul@plier effect on the money supply.

•  Because banks are highly leveraged, a small change in the value of a bank’s assets causes a large change in bank capital. To protect depositors from bank insolvency, regulators impose minimum capital requirements.


Summary

•  The Federal Reserve is the central bank of the U.S. The Fed is responsible for regula@ng the monetary system.

•  The Fed controls the money supply mainly through open-‐market opera@ons. Purchasing govt bonds increases the money supply, selling govt bonds decreases it.

•  In recent years, the Fed has set monetary policy by choosing a target for the federal funds rate.


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